Steps to protect against the potential fiscal plunge

By J. Bradford DeLong

Unless something unexpected happens, the US’ many legislated reductions in taxes over the past 12 years — all of which have been explicitly temporary — will expire simultaneously tomorrow. US tax rates will revert overnight to their Clinton-era levels.

Some of these reductions were implemented to fight what was seen four years ago as a temporary downturn. Although their supporters wanted to make them permanent, claiming that they were temporarily allowed for the circumvention of procedural requirements in the legislative process that Democrats had created in a vain effort to guarantee fiscal sanity.

The immediate increase in tax rates is only part of the story. At the same time, automatic reductions in the defense budget and “discretionary” domestic spending — agreed to by both Democrats and Republicans in the summer of last year — will take effect.

Couple these tax increases and spending cuts with the provisions of “Obamacare,” the US healthcare reform championed by US President Barack Obama, and, as of tomorrow, the US’ long-run structural budget deficit disappears. The restored tax rates will, for the foreseeable future, be sufficient to support the US defense establishment, the growing US social insurance system and a moderate — albeit inadequate and suboptimal — amount of other “discretionary” federal spending.

The US national debt to GDP ratio will be on track to fall from its current level of 75 percent to 50 percent by 2035. Moreover, the US will begin running primary budget surpluses — the fiscal balance minus interest payments on existing debt — by 2015.

So why is the prospect of going over the “fiscal cliff” not greeted with enthusiasm? Yes, there will be big spending cuts — which will hit defense contractors, doctors with Medicare patients and all who benefit from or rely on government discretionary spending — and substantial tax increases. However, to balance the budget in the long run, either taxes have to go up or spending has to go down relative to some baseline, or both.

There are two reasons why deficit hawks are not declaring victory.

First, many who call themselves deficit hawks are really spending hawks: They believe that US social insurance is too generous to the unemployed, the disabled, the elderly and the sick, and that by far the best policy is to cut back on such programs rather than raise taxes to pay for them. However, they fear that calling for spending cuts will be unpopular, unlike, they hope, demands to balance the budget. For them, the problem with the fiscal cliff is that it does not cut spending enough and raises taxes too much.

Second, and more important for those who worry about the US economy’s health, the process is not well-described by the term “fiscal cliff.” It is, rather, an austerity bomb that hits an economy in which unemployment remains high, the employment-to-population ratio remains horrifyingly low and there are only feeble signs that the large gap between current and potential output is closing.

The past two months’ run-up to the austerity bomb’s detonation has already reduced projected real GDP growth next year from 3 percent to 2.5 percent, and has raised likely end-2013 unemployment from 7.5 percent to 7.7 percent. Each day from tomorrow to June 30 that the damage continues will have a roughly linear impact on economic performance next year, reducing the likely full-year real GDP growth rate by 0.0084 percent — and only if a deal is ultimately reached that would have caused no economic harm next year had it been reached on Nov. 10 this year. If no deal is reached by June 30, the US’ likely real GDP growth rate next year will be minus 0.5 percent, with the likely unemployment rate returning to 8.9 percent.